If you’ve been anywhere near CNBC recently, you are certainly aware of the massive disaster that Facebook just pretended was an earnings report. It caused a 25% drop in the share price, and was the single biggest wipe out of investor equity in history. Unfortunately, in contrast to the Paypal drop, I happened to be involved with this one… Essentially, the company reported a substantial slow down in the company’s revenue expectations from a combination of factors, experienced their first ever sequential decline in DAU’s and announced the widening of losses in their Reality Labs segment with nothing to really show for it. Now, the question really becomes what to do with your shares, and whether the market overreacted.
What was the big deal?
The company actually reported relatively good earnings for Q4. They beat revenue expectations, and slightly missed on eps. This was a mixed bag, but what really sent it down was the guidance. Management suggested that Q1 revenue would grow between 3-11%. This is well below estimates and historical expectations since they normally grow between 15 & 20%. More concerning, their DAU’s decreased for the first time ever. Now, this was a sequential decrease and not yoy. Also, this was only in the Facebook app (where even there, MAU’s still went up) - in the whole family of apps there was still growth. Essentially, yoy, there was still an 8.5% yoy user growth number across all platforms. If this trend continues going down though, it could be problematic since it would make the company wholly dependent on ARPU growth. The reason there is so much fear around this is because of the law of large numbers, they have 3.6+B users across platforms, meaning that almost half of humanity uses their services, and so it isn’t far fetched for growth to stop or significantly slow down.
In a double whammy, Meta announced a $10B expected headwind from Apple’s privacy changes which are impacting their ability to target ads, and determine their efficacy. Essentially, the theoretical growth engine that is supposed to keep them growing outside of users is also in trouble. This seemingly affected them way more than their competitors because Snap & Pins both reported good earnings - though this is likely attributable to their SMB exposure. Also, they announced that competitive pressures, specifically from TikTok were causing engagement concerns, especially in young demographics. This led to them pushing Reels really hard in the hope of competing. Unfortunately, the monetization on the product is temporarily lower than the rest of Facebook, though management says it expects meaningful improvement. Finally, they announced they were expecting over 15B in expenditures related to Reality Labs, a project that is bringing in about 1B in revenue. Of course, we were all aware of the Metaverse transition, but until now didn’t realize the sheer lack of contribution from the endeavour. On top of that, the company announced no real plans associated with how they are going to monetize or a concrete plan on how they would be the biggest player in the space, saying only that its future ownership is unclear. To sum up, they said they were going to spend over 15B (and growing) a year on a project that is 10-15 years away from real returns and with no concrete understanding of what it will look like. This reality means that you need to really believe in their vision, or be willing to ignore the massive losses and pretend that side of the business doesn’t exist…
The good parts
Despite the massive plunge, there was some good news. This quarter was good, and they seemingly made good progress on starting to monetize their messaging apps through things like text-to-order. If they can eventually get their WhatsApp & Messenger businesses to contribute meaningfully, the ARPU number still has a long runway for growth. Also, their earnings power is still strong despite their VR experiments, with over 40B in net income. The IDFA challenges from Apple are likely short-term headwinds since the company spends so much on R&D that they will almost certainly find a way around it within the next year. Management also announced that they repurchased almost 15B of stock that quarter, which if annualized would be close to 10% of shares at current prices (massively boosting eps potential). Finally, despite Q1 problems, the company was much more upbeat about the second half with things like inflation & supply chain improving and potential solutions to their IDFA problems. They still grew ARPU almost 15%, and without the IDFA headwinds, it is likely that earnings & revenue would be similar to our expected growth range.
Overall Decision
Facebook, or Meta as it is now known, is likely to solve many of its issues over the next year, with IDFA & supply chain likely going away (though this is of course not guaranteed). They are still likely to face challenges with user growth, especially since they called out competition, but if the trend reverses, there could be a big narrative shift. In terms of Reality Labs, the investments are problematic, but 15 years from now we might be thrilled as shareholders if they do end up owning the literal world that we exist in online & their Quest projects work out.
Overall, their business is still going strong (57B in net income without Reality Labs), and especially with buybacks, I don’t think it is far-fetched for them to return to their normal eps growth rates in 2023. There is a cloud of negative sentiment surrounding the stock, but to determine if a company is good value we need to look at an Exit Multiple analysis:
If you believe the current issues will persist and they will only be able to grow around 6% for the next 5 years, dropping to around 5% after that, you would get a value of 370B with a 34% net income margin and a 15 f p/e at that point (for the slow growth rate), with an 11% required return. If you do not think they can rebound, and believe the VR experiment will never produce returns, this is most definitely not for you
However, if you take a more realistic view with most of the issues being solved over time, and think they can grow at 15% a year for 5 years, and then 12% after that on the back of all their initiatives, they would be valued at $1 Trillion, with a required return of 11%, a 34% net margin and a 20 fp/e.
If you want to take a conservative middle of the road estimate, with 9% growth for the next 5 years, and 7% the 5 years after that, with a 17.5 fp/e and a 34% net margin, you would get a valuation of $577B
Considering the company’s 40B of cash on hand, the company has an EV of around 500B. In my opinion, I think Meta has some of the best management and innovation in the world, and I think it is quite likely that they return to decent growth, especially with share repurchases and with the sheer amount of cash they generate. Let’s not forget that if we do a 7% to 5% growth estimate with a 15 fp/e estimate but exclude Reality Labs expenses you would get a value of 725B. I also do think that over time, we will spend a ton of time in a VR world and if Facebook (especially with their dominance through Oculus) is able to own even a part of that, then we will be handsomely rewarded as shareholders. In general, after the massive drop, I think the earnings of the business are being undervalued and the risk-reward is out of sync. Keep in mind though that similar to Paypal, the negative sentiment is incredibly high and it could be dead money. I am personally being cautious and think Paypal is a better buy from here since they have a clearer path back to growth. However, at the end of the day I think both 30+% drops were overblown by investors and represent potential buying opportunities for those willing to overlook short-term headwinds & hold shares for a while.
By: Mateo Gjinali
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